06/16/2013 05:16 pm ET Updated Aug 16, 2013

Why the Government Needs to Budget Over the Infinite Horizon

How far into the future should governments budget?

Economic theory has a clear and rigid answer. But it's not one economists like to give -- for two reasons. First, it's not one people easily comprehend. Second, it's not one that politicians, whose attention most economists covet, like to hear.

The answer is that governments need to budget out to infinity.

Infinity is a very long time. But economic theory also tells us that in budgeting out to infinity, we should place less weight on distant government expenditures and tax receipts. Specifically, we should include in our budgeting, not actual future expenditures and taxes, but their present values.

Present value stands for the value right now -- in the present. And the value right now of getting one dollar in the future is smaller the longer you have to wait for it. The reason is simple. You can put aside less than a dollar today, earn interest on that saving and end up with a dollar in the future. If you can invest at 3 percent, you only need to put aside 41¢ today to end up with $1 in 30 years. So 41¢ is what $1 in 30 years is worth today.

The fact that economics tell us to discount, as in make less of, each dollar a government owes and receives in the distant future doesn't mean we can ignore those obligations and receipts, especially if there are loads of future obligations relative to receipts to be discounted.

Take the just-released 2013 Trustees Report on Social Security's long-run finances. Table IVB6 shows an infinite horizon fiscal gap of $23.1 trillion separating the system's projected costs and taxes net of its trust fund. This massive shortfall, which grew a whopping 8 percent last year, is 50 percent larger than U.S. GDP and almost twice the federal debt held by the public.

Table IVB6 also reports Social Security's 75-year fiscal gap. It's only $9.6 trillion or 41 percent of $23.1 trillion. Thus, the 75-year fiscal gap hides three fifths of the system's true long-term shortfall.

Eliminating the infinite horizon fiscal gap requires an immediate and permanent 4 cents on the dollar hike in Social Security's current 12.4 percent FICA tax rate. That's a 32 percent increase, implying that Social Security is 32 percent underfunded! Alternatively, we could cut all Social Security benefits immediately and permanently by 22 percent.

Social Security began reporting its infinite horizon fiscal gap 2003. Back then it was $10.5 trillion. On an inflation-adjusted basis, the gap's risen 74 percent leaving the system in far worse shape than when the 1983 Greenspan Commission "fixed" it.

The Commission, like the current Trustees, looked out only 75 years. In so doing, it ignored not just the 30 years between 2057 and 2087 now in the current 75-year window, but all the years after 2087, when today's and tomorrow's children will be alive.

Ignoring the distant future when our kids' welfare is at stake is morally repugnant. But it's also forbidden by economic theory. Here's why. Economic theory doesn't tell us whether to call any given dollar the government takes from us "taxes" or "borrowing." Nor does it tell us whether to call any given dollar the government hands to us a "transfer payment" or "repayment of principal plus interest."

Economics is about real policy, not the language used to describe policy. But the government's choice of words, not its actual fiscal deeds, will dictate its cash flow projections and the fiscal gap it reports over any finite budgeting horizon, be it the 10-year horizon Congress uses or the 75-year horizon the Social Security Trustees favor.

Indeed, Social Security's $23.1 trillion fiscal gap is off-the-books because politicians from both parties chose to call our FICA contributions "taxes," rather than "borrowing," even though they simultaneously made promises to repay our "taxes" with future "benefits" that could just as well be called "repayment of principal plus interest."

This is the real reason that politicians and their "trustees" budget over short-term horizons. Doing so let's them label their policies in ways that leave most obligations outside the budgeting horizon.

But, here's the catch. Any internally consistent set of labels will produce the same infinite horizon fiscal gap. But each will produce a different fiscal gap over any finite horizon, including 75 years. In short, then, the 75-year fiscal gap of Social Security is not pinned down by economic theory. It can be any size anyone wants to report based on her own internally consistent labeling choice. So 10-year, 25-year, 50-year, and 75-year fiscal gaps literally have no economic meaning because they measure our labels - our words, not our policy.

For the U.S. government as a whole, the infinite horizon fiscal gap is a whopping $222 trillion! It's elimination requires not a 32 percent immediate and permanent tax hike in Social Security FICA taxes or a 22 percent immediate and permanent cut in Social Security benefits, but either a 64 percent immediate and permanent tax hike in all federal taxes or a 40 percent immediate and permanent cut in all expenditures apart from servicing official debt. So, Social Security's enormous fiscal problem is just a molehill in front of a mountain of horrendous obligations our politicians and their "trustees" are ignoring with their careful choice of words and their finite budgeting horizons.

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